9.19.2011

Wolfers on Loan Forgiveness = Analytical Fail

Let us start off this post by saying that Justin Wolfers is a very intelligent person. Not that it is 100% dispositive, but the professor has his own page on the Wharton website chock full of fancy titles and publications. And if being a professor at Penn wasn't enough, those perusing his vitals will also note associations with institutions like Stanford, Princeton, Brookings and the Federal Reserve. In short, he is not the sort of individual that we have any business going toe to toe with on economic analysis. However, there is something in his recent Freakonomics post 'Forgive Student Loan? Worst Idea Ever.' that just isn't sitting right from our perspective.

The issue of student loan forgiveness is a touchy one with passionate advocates on either side. Unlike other debts, student loans cannot be discharged in bankruptcy. Sometimes even death doesn't erase the burden. The individuals signing the papers for debts which can exceed six figures are often young, uninformed and naive/overly optimistic about post-graduation employment possibilities. And those who take the debts on are often forced to start paying them back when they are just starting out in entry-level positions and are therefore most financially insecure. There is also a significant percentage of the population which ascribes to the idea that forgiveness is morally acceptable because the loans were made by predatory corporations in the first place.

On the other hand, college is statistically a good gamble over the long-term as lifetime earning potential will largely overshadow the downside of loan repayment. And those taking the loans, while young, are no younger than those we ask to die for our country. Loanees have the tools at their disposal to understand the burdens they are taking on. Finally, countering the 'corporations are just out to get us' argument would be the contrasting moral obligation line of reasoning; essentially that paying back debts is a responsibility, and shirking that responsibility is not fair to society.

Most of the arguments above can be fitted loosely into two different political philosophies. To erase any ambiguity most of those who advocate for loan forgiveness tend to support Democrats while those with Republican leanings tend to be against the idea. Of course, this is not hard and fast. Many people I know with liberal leanings of course feel responsible for their debts. And, some I know who consider themselves to be conservatives would probably be happy to have their debts erased. However, it tends to be organizations like Moveon.org and legislators with a D after their names who typically support forgiveness plans with Republican legislators poo-pooing such notions.

While I cannot claim to know Wolfers' political leanings, he is overwhelmingly sides with what we are describing as the 'Republican' viewpoint on this issue. To be clear, and despite having an obscene amount of debt as a result of a recent three-year break from the workforce, I am as well, almost entirely due to the moral responsibility argument (though I can't lie...there is some appeal in knowing that these burdens could be wiped out Fight Club style). I knew that I would have a big bill to pay after graduation; my cost/benefit analysis nonetheless tilted in favor of taking it on.

In other words, Wolfers and I agree philosophically that those who take on debt burdens should be responsible for them. In his words:

This is a bunch of kids who don’t want to pay their loans back. And worse: Do this once, and what will happen in the next recession? More lobbying for free money, rather than doing something socially constructive. Moreover, if these guys succeed, others will try, too. And we’ll just get more spending in the least socially productive part of our economy—the lobbying industry.

However, while I can agree with his political/philosophical analysis, Wolfers' economic analysis leaves something to be desired. Again, in his words:

This is the worst macro policy I’ve ever heard of. If you want stimulus, you get more bang-for-your-buck if you give extra dollars to folks who are most likely to spend each dollar. Imagine what would happen if you forgave $50,000 in debt. How much of that would get spent in the next month or year? Probably just a couple of grand (if that). Much of it would go into the bank. But give $1,000 to each of 50 poor people, and nearly all of it will get spent, yielding a larger stimulus. Moreover, it’s not likely that college grads are the ones who are liquidity-constrained. Most of ‘em could spend more if they wanted to; after all, they are the folks who could get a credit card or a car loan fairly easily. It’s the hand-to-mouth consumers—those who can’t get easy access to credit—who are most likely to raise their spending if they get the extra dollars.

Wolfers has to be underestimating the multiplier effect that extra dollars for graduates could have. Perhaps this is because he seems to be conflating two groups; those who have student debts with those who have an education. While the Venn diagram for those two groups obviously has a very fat middle, there are many more college graduates than individuals with loan debts. For example, some graduates had help from parents, or scholarships, or have simply paid their loans back already. Those individuals are most likely to be in the positive financial situation that Wolfers describes above; he seems to be talking about older, well-established college grads. His description does not match those who have most recently graduated (and thus have the debt to forgive in the first place).

This latter group is more statistically likely to be in their 20's and just 'starting out.' Many of them do live hand to mouth with savings rates approaching zero. Particularly in the current economy, they are not necessarily able to get credit, or even jobs. To the extent that they can find work, they are typically making purchases on furniture, work clothing and cars. They are likely to be spending any discretionary money on entertainment, such as bar trips, restaurants and vacations. While these items are all more or less defensible from a financial responsibility standpoint, they all undoubtedly contribute to, and have a multiplier effect on, the economy.

To me, a cleaner macro argument would center on the idea that the economic system could possibly come closer to collapsing if student debts were written off than it ever did due to bad housing loans. Or that the federal government backing up trillions of dollars if forgiven debts would make the economy so bad that those whose debts were forgiven would be jobless anyway, leading to a downward spiral worse than the country finds itself in now. Both are economically supportable hypotheses due to the absolute dollars figures that are thrown around in the forgiveness scenario.

Despite his exceptional economic chops, it is clear that Mr. Wolfers would have a stronger argument by avoiding the dismal science in this situation. His moral argument that debts are a responsibility as well as others that suggest that forgiveness creates moral hazard and is just bad educational policy ring much stronger than his macro arguments. Perhaps his time at Wharton has put him out of touch with the realities of average college grads, perhaps his obvious academic acumen enabled him to avoid the bitter taste of student debt. Maybe he is just looking for an economic argument to boost his political one. However, in the end it is clear that his economic analysis undermines his argument more than underpins it.

9 comments:

"To me, a cleaner macro argument would center on the idea that the economic system could possibly come closer to collapsing if student debts were written off than it ever did due to bad housing loans. Or that the federal government backing up trillions of dollars if forgiven debts would make the economy so bad that those whose debts were forgiven would be jobless anyway, leading to a downward spiral worse than the country finds itself in now. Both are economically supportable hypotheses due to the absolute dollars figures that are thrown around in the forgiveness scenario."

First, I found Wolfers' post remarkably Antoinettean. Second, there's a lot of misunderstanding of who owns these debts, issues them, guarantees them, &c. Since summer 2010, all new federal student loans have been directly lent by ED. Banks now only act as loan servicers. This means new student debts are owed to the government. Additionally, in 2008 the government began buying up the older guaranteed loans, so now its holdings of nonrevolving debt, according to the Fed's G.19 Release, are $370.1 billion. It's growing by about $135 billion per year.

If student debt were forgiven, there would be no Lehman-style financial collapse. The government is not a bank. It does not make money off loans. It collects revenue by taxing people. Moreover, there's a lot less student debt than there was housing debt ($900 billion vs. $8 trillion), so the problem isn't as significant in scope. Canceling a loan isn't spending money; it's telling a debtor not to bother paying a loan back. It doesn't worsen the financial position of the government because the government can never go bankrupt.

As to the second plausible scenario, forgiving student debt can't worsen the job situation because increasing amounts of these debts are owed to the government. The guaranteed lenders get their money back, so it should be neutral for them, and borrowers have more spending money.

People like Wolfers need to recognize that the greater danger is a citizenry saddled with debt to the government that interferes with private sector consumption. The government's mandate is to ensure widespread prosperity, not to make money on loans. The fact that the government is going to lose money on student loans because it uses accrual accounting rather than fair value accounting, and that it doesn't hold higher education institutions accountable (grad inflation, job prospects, etc.--Gainful Employment Rule aside) means the 21st century government has rediscovered peonage.

Thanks for reading and thanks for the insightful comments on the federal government's current role in the lending system.

I think your comments render my macro analysis moot to a degree when it comes to new loans, I believe that some of the existing 'old' debt would still impact holder's balance sheets if it were forgiven (maybe I am wrong on the mechanics, but I am personally aware of some debt being serviced by private banks). I suppose it would depend on what an actual forgiveness plan would look like. Based on other legislation I have reviewed in the past, I have no doubt that it would be complicated enough after a few go-rounds in committees that there would be some impact on a bank somewhere.

I will concede that it probably doesn't put us closer to the financial brink than the Lehman situation all alone, but I think we might be able to agree (based on the last bit of your comments) that this government intervention in the lending markets is nonetheless leading to broader problems.

Even if the US government couldn't go 'bankrupt' the fact that it is backing up nearly a trillion in loans is just another straw on the camel's back of our economy, which is arguably more fragile now than it was around the time Lehman was having its issues.

While we might not be headed for a Lehman-esque near collapse, I would say that the money for forgiveness ultimately needs to come from somewhere. And while circumstances (reserve currency, small likelihood of rapid sell-offs of US debt by creditors etc.) won't lead to imminent financial collapse in the US, its citizens will undoubtedly have to pay the piper at some point, likely in the form of higher inflation.

Incidentally, I nipped over to your blog and think that your comment is worth a plug for what its worth:

I should add that you're right about the old guaranteed loans. I think they totaled $713 billion a year ago. forgiving those would require the government to cough up the money, but Wolfers thinks that (a) these loans are good when they're not, so the government will have to intervene one way or the other, and (b) the multiplier is so low that forgiving guaranteed loans would be like giving Jamie Dimon another tax break. Also, the government has shown a willingness to buy up guaranteed loans, and it'll do more of that in the coming fiscal year. If it's willing to rescue those lenders, there's no reason it shouldn't aid the students. Alternatively, it could just change the law and treat all student debt like other consumer debt, cancel the guarantees to the loans, and see what happens.

As for the hundred billion dollars or so of private loans, restore the bankruptcy protections; those lenders are on their own.

Regardless, the worst this would do is cause Sallie Mae and NelNet to collapse, tuition to plummet, for-profits to close, and cause a little inflation when we already have a mountain of private sector debt. Like you I don't know Wolfers's political leanings, but the student debt problem is avoidable yet he's choosing not to avoid it.

Well I suppose that we agreed from the start that Wolfers' economic analysis was incorrect... and you have since managed to pull me back from the brink regarding the threat that forgiveness would pose to the broader system.

I guess all that is left would be the moral arguments, and those will be more difficult to sway me on, regardless of my personal situation. After all, I was against bailouts of the banks due to moral hazard...I can't then argue that I should personally be bailed out without first scraping the hypocritical stench from my tongue. This is especially true considering that I was aware of the risks of taking these loans when I signed on the dotted line.

I guess I will stubbornly cling to advocating against a student loan bailout publicly (morally if not economically) and do my best to suppress my glee in the unlikely case that one were to happen.

I will be retiring in 15 more years (I hope) at age 65. I will still have student loans over $150K and no way to pay them. The government will take 1/2 my ss check and make me live in the street as no one can live on $500-$700 per month. Who will be helping the older American's? What will this be teaching the younger American's? It will teach them that a college degree is worthless and just go work at McDonald's and do not try to get ahead in life. You are better off poor where you can collect welfare and food stamps!

I believe that there should be a ceiling placed on the life of student loan debt. That only a certain amount of fees and interest can be applied to a loan say over 10 years. After that no more fees or interest can be added to it. It would make it much more easier to pay off. Also if a loanee has hardship and has to go into deferrment or by chance ends up in default, the amount doesn't balloon to horrendous amounts to be repaid back. The hardship of the debtor does NOT benefit the student loan lenders. As it is now it benefits. This is not government working for the people, its government enforced slavery. I believe if the ballooned amount on every student loan is removed that was a result of deferment or hardship it would be a win-win situation. The loans could be repayable, the government or economy is not in economic danger.

Anonymous above is exactly right. Many of us are in the position of Dawn Herridge above- this is not all about "kids". I've never incurred a late fee, but due to illness after grad school had my loan in deferment for some time. The interest nearly doubled it. I've been paying for nearly 20 years- literally 10's of thousands of $$ in interest above the original loan amount. At nearly 50, I have no retirement savings, or even a savings account. A few years ago, after being unemployed for 2 years, I had to go through bankruptcy, but came out w/ 40k in student loans still owed to Sallie Mae. I now teach at community college where I am happy students are not taking these huge loans and becoming indentured servants to Sallie Mae for the rest of their lives. I pay between 1/3 and 1/2 of my take home income to my student loan debt to be done with it before I retire. Let me reiterate that my original principle was paid off long ago. With $800 more per month at my disposal, I personally could do a lot for the economy.

Thanks to everyone who has visited the post and a special thanks to everyone who has shared some very personal stories.

I can certainly empathize with the plights of some of our unfortunate commenters; as noted in the post I am in an unenviable position myself with regards to debt burden. As for my prospects to pay them off, let's just say that most high-paying legal jobs don't leave much time for blogging...

I am not sure if the situation we are discussing is emblematic of broader problems with the educational system or if it is really down more to how the student loan system works. I am also aware that everyone is in a different position with regards to illnesses, job loss etc. which could make debt burdens untenable.

However, in my case, I went into law school with open eyes, and I am not sure it would be responsible of me to say that the government should bail me out. I would also be curious to know how the commenters above would feel if my debt were wiped out right now after they have paid for years? I would guess that they wouldn't be too concerned, but if anyone has a thought on that, I would appreciate it.

At any rate, thanks again for the comments, I feel like this kind of dialogue is far more productive than what I see in a lot of other places these days, and that makes the work I put into it very worthwhile.

I'm not saying all debt should be wiped out except for certain circumstances that are protected in bankruptcy. Old student loan debt should be forgiven or significantly decreased. As for loans like yours, JS, there should be a ceiling on how much interest can be added and should you unfortunately experience a hardship, that only a certain amount of fees & interest can be added after your deferment. Also if a loan gets transferred to another loaner no more fees can be added. In other words fees can only be added once or maybe put a cap on the fees and nix the interest added. Something has to be done and regulated to protect the consumer. Thanks JS for creating this site.